Non-financial FTSE 100 companies are subjectively reporting exceptional items, with a majority reporting underlying earnings that exceed unadjusted operating profits, according to a new report by Standard & Poor's Rating Services.

The report, released 18 Feb., reviewed the annual reports for the last four years of 82 non-financial companies in the FTSE 100 index. Standard & Poor's review found that over the last four years, an average of 73 percent of the companies reported an adjusted operating profit that exceeded the International Financial Reporting Standards (IFRS) operating profit. Additionally, 43 of the 82 companies reviewed presented adjusted operating profits greater than IFRS operating profits in each of those four years. Not surprisingly, the study found that companies more often identified reconciling items that boosted adjusted profit figures than items that decreased those figures.

“Companies reporting under IFRS frequently separate exceptional or special items they believe are non-operating or nonrecurring to produce underlying or adjusted earnings information that purports to better reflect business performance,” Sam Holland, the London-based primary analyst for the report, wrote. “However, in our view, taking underlying earnings without understanding the nature of the exceptional items that a company has excluded can sometimes give a misleading picture of its earnings and future performance.”

The irregular separation of exceptional items “can lead users of financial statements to focus on companies' subjective, adjusted profit measures, rather than on the unadjusted, audited figures that the International Accounting Standards Board (IASB) mandates companies to disclose,” Holland wrote.

The report found a “systematic exclusion” of certain costs from many of the companies adjusted figures, including long-term asset impairments and the amortization of certain intangible assets. There can be a sound rationale for some of those exclusions, like long-term asset impairments, which tend to be large and irregular, the report noted. However, the impairment should not be ignored entirely in the financial analysis, the report said. But the study found little explanation as to why 34 of the 82 companies reviewed also excluded the amortization of certain intangible assets from adjusted profit measures, a practice Standard & Poor's does not endorse.

The report also noted that restructuring costs deemed exceptional actually can occur year after year as companies update their operations to remain competitive. In fact, 21 of the companies reviewed excluded restructuring charges from underlying earnings or adjusted profit measures, even though they had restructuring charges in each of the last four years of financial reports.

Standard & Poor's is calling for enhanced company disclosures, more prescriptive and specific guidance for auditors, and better auditor assurance of underlying earnings and exceptional items. “Where such financial metrics are disclosed, we would prefer them to be incorporated into the financial statements to elevate the level of audit assurance,” the report said.

Standard & Poor's also pointed to work being done by the Financial Reporting Council (FRC) and European Securities and Markets Authority (ESMA) to help provide additional guidance on the issues.

“The welcome enhanced regulatory scrutiny on adjusted earnings and exceptional items lead us to believe that we could be entering a new era of financial reporting in the U.K., with companies less likely to present (and auditors more ready to challenge) misleading underlying profit figures,” Holland wrote. But he noted that improvements will come gradually, and full comparability in reporting may be some way off.

“In our view, investors and other users of financial information should exercise professional skepticism and carefully scrutinize underlying earnings and exceptional items before reaching their own view of a company's performance,” Holland wrote.

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